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The Cost to Firms of Cooking the Books

Published online by Cambridge University Press:  06 April 2009

Jonathan M. Karpoff ,
D. Scott Lee  and
Gerald S. Martin
Jonathan M. Karpoff
Affiliation:
karpoff@u.washington.edu, Foster School of Business, University of Washington, Box 353200, Seattle, WA 98195
D. Scott Lee
Affiliation:
slee@tamu.edu, Mayes Business School, Texas A&M University, 4218 TAMU, College Station, TX 77843
Gerald S. Martin
Affiliation:
gmartin@american.edu, Kogod School of Business, American University, 4400 Massachusetts Ave NW, Washington, DC 20016.
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Abstract

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We examine the penalties imposed on the 585 firms targeted by SEC enforcement actions for financial misrepresentation from 1978–2002, which we track through November 15, 2005. The penalties imposed on firms through the legal system average only $23.5 million per firm. The penalties imposed by the market, in contrast, are huge. Our point estimate of the reputational penalty—which we define as the expected loss in the present value of future cash flows due to lower sales and higher contracting and financing costs—is over 7.5 times the sum of all penalties imposed through the legal and regulatory system. For each dollar that a firm misleadingly inflates its market value, on average, it loses this dollar when its misconduct is revealed, plus an additional $3.08. Of this additional loss, $0.36 is due to expected legal penalties and $2.71 is due to lost reputation. In firms that survive the enforcement process, lost reputation is even greater at $3.83. In the cross section, the reputation loss is positively related to measures of the firm's reliance on implicit contracts. This evidence belies a widespread belief that financial misrepresentation is disciplined lightly. To the contrary, reputation losses impose substantial penalties for cooking the books.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 43 , Issue 3 , September 2008 , pp. 581 - 611
Copyright
Copyright © School of Business Administration, University of Washington 2008

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